Active Stocks
Thu Mar 28 2024 13:49:19
  1. Tata Steel share price
  2. 155.60 1.80%
  1. HDFC Bank share price
  2. 1,454.40 0.95%
  1. Power Grid Corporation Of India share price
  2. 277.00 2.20%
  1. ITC share price
  2. 430.30 0.54%
  1. State Bank Of India share price
  2. 754.80 2.83%
Business News/ Opinion / Online-views/  Satyam, oranges and lemons
BackBack

Satyam, oranges and lemons

Satyam, oranges and lemons

Premium

Satyam’s B. Ramalinga Raju liked to read science fiction. Those who are trying to make sense of what he has done would do well to read an economist called George Akerlof, who won the Nobel Prize in 2001 with Michael Spence and Joseph Stiglitz.

Akerlof wrote a seminal paper in 1967, though it did not get published till 1970 because many academic journals rejected it. Akerlof wrote on the market for lemons, which is American slang to describe something believed to be good, but which proves to be defective; something like the company that Raju founded.

The most popular example to illustrate Akerlof’s brilliant insight—into why unequal access to information can force some markets collapse—is used cars. There are good used cars and bad used cars (the lemons) on sale. But only the individual sellers know how good or bad their used car is. The buyers are more or less in the dark. There is information asymmetry in this market.

The buyers then make an assumption that all the used cars in the market are of the same average quality and deserve the same price. The sellers with well-maintained cars who rightly expect higher prices for their vehicles will drive away in response. The best cars gone, the average quality of the cars in the market will fall and so will the common price for them. Once again, sellers with better cars will back out. The average quality and price will fall even further. And this process will continue till only the most damaged cars are left in the market. We will be left with lemons.

So what does all this have to do with Raju and all that missing cash in the balance sheet of Satyam Computer Services?

Akerlof’s insights can be adapted to any market that satisfies two conditions: It has goods with different levels of quality and sellers know more than buyers. Akerlof provides several examples—insurance and employment of minorities, for example. He also has a detailed discussion on the price of dishonesty in countries such as India.

An underdeveloped country is likely to have far greater differences in quality than a developed economy would. Akerlof gives one example: food. Indian housewives, he says, “…must carefully glean the rice of the local bazaar to sort out stones of the same colour and shape which have been intentionally added to the rice. Any comparison of the heterogeneity of quality in the street market and the canned quality of the American supermarket suggests that quality variation is a greater problem in the East than in the West."

Just as the Indian housewife has to work hard to identify the “lemons" that the shopkeeper is trying to sell her, so the Indian investor has to work hard to identify the “lemons" in the stock market. The independent directors on the board of a company and the statutory auditors are supposed to help us in this task, but we all know what happened at Satyam. There has been a similar failure in the global bond market when credit rating agencies failed to tell investors the true risk in mortgage-backed securities.

What Raju has done is an old problem in India. Which is why corporate reputation should matter far more in a market such as ours.

“In India a major fraction of industrial enterprise is controlled by managing agencies… In turn, a second major feature has been the dominance of these managing agencies by caste (or, more accurately, communal) groups," Akerlof wrote in his 1970 paper.

Managing agencies were a unique institution that emerged in India. The promoters of a new venture would have the initial capital or technology, but would ask a managing agency to run the business because of its reputation, which would raise investor confidence and help raise further capital. These agencies were paid either a fixed percentage of a company’s sales or profits.

Managing agencies were banned— perhaps unnecessarily—after independence. But this form of corporate governance has survived into our era in a new form because of promoter groups that, just like the old managing agencies, manage companies with minuscule ownership. And the Satyam case shows that there is information asymmetry here as well: The promoters know more about the company than outside shareholders do.

Without going into a detailed examination of the commonalities and differences between the old managing agencies and the current crop of promoter-led corporate groups, the huge differences in management quality could—as in the market for used cars—ensure that bad managements drive out the good. Akerlof had warned against such a possibility: “The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence."

Defective goods can destroy markets. That is the big threat to Indian business from the Satyam scam.

Your comments are welcome at cafeeconomics@livemint.com

Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
More Less
Published: 21 Jan 2009, 12:02 AM IST
Next Story footLogo
Recommended For You
Switch to the Mint app for fast and personalized news - Get App